Economic Commentary
The Fed closed out 2024 with two rate cuts on the books, a considerable downgrade from the initially projected six cuts a year ago. As we enter 2025, benchmark Fed Funds rates are 4.5-4.75% percent. The central bank has said it will pause for a bit and see how inflation and the return to President Trump’s policies affect the economy and markets.
On the inflation front, progress has underperformed the Fed’s expectations in several areas, most notably shelter. In late 2023, the San Francisco Fed forecasted shelter inflation possibly turning negative by mid-2024, however shelter is still running hot at a 4.8% annual increase. Overall, the Fed’s preferred inflation metric, the Core Personal Consumption Expenditures Index (Core PCE) made little progress over the course of 2024, declining just 0.1% from 2.9% to 2.8%, still well above the 2% target. Looking at the most recent six-month trend, we can see that inflation accelerated in 2024 and still hasn’t come down to the sub-2% six-month trend where it began the year.
Figure 1. Six- and Twelve-month Annualized Core PCE Inflation
Source: US Bureau of Economic Analysis, chart by VestGen Investment Management.
The Fed doesn’t seem overly concerned about the slow progress in bringing down inflation, since the data is still gradually trending lower. The central bank has however expressed concerns over the uncertainty surrounding several key policies of the new Trump administration and their potential inflationary effects. President Trump’s promises of tariffs, tax cuts, and deportation are viewed as inflationary, although it is uncertain if any of these promises will be achieved.
The good news is that while the Fed awaits clarity on the new administration’s plan implementation, US Gross Domestic Product (GDP) growth could possibly come in at 3% or better for Q4, 2024, which would mark a third consecutive quarter above 3%. The economy has been driven by consumer spending, which accounted for nearly 80% of GDP growth in the first three quarters of 2024. US GDP growth is impressive but it remains insufficient to cover the ever-expanding Federal deficit. While the proposed tax cuts would likely help to further expand the consumer-driven economy (potentially at the cost of higher inflation), it will be a tough sell for the Trump administration to lower taxes without corresponding cuts to federal spending, given the continual debate over the deficit and debt ceiling in Congress. Talk of government spending cuts, especially via the newly formed, unofficial Department of Government Efficiency (termed DOGE), headed by Elon Musk and Vivek Ramaswamy, is nothing more than a work in progress at this time.
Market Commentary
US stocks were able to ride the momentum off the August lows through the quarter, getting an election bonus that eventually faded in December. The S&P added 2.4% in the fourth quarter to make an impressive 25% total return for CY 2024. Despite the strong market performance, the top-heavy nature of the market remains a concern, with the top 10 most highly valued companies in the S&P 500 now representing 38% of the index’s market capitalization, a record. These mega-cap companies have consistently delivered on earnings quarter after quarter, providing some justification for their market share dominance, and happen to be at the forefront of high-growth industries such as artificial intelligence (AI) and autonomous vehicles.
During the fourth quarter, Consumer Discretionary stocks were the best performing sector with a 12.2% gain, largely due to Tesla’s (TSLA) 54.4% fourth quarter surge. Communication Services, Financials, and Technology were also positive for the quarter while all other sectors posted quarterly losses. The Materials sector was the worst performer, down -12.2% during the quarter.
The mixed returns highlight the poor market breadth that has limited the duration of market rallies during the past year. Market breadth refers to the number of stocks advancing vs declining on a given day, week, month, or quarter, reflecting whether market moves are broad-based (more stocks) or narrow (fewer stocks). The chart below shows the McClellan Oscillator, a smooth measure of market breadth, below the S&P 500 performance chart. There was a drop in breadth immediately preceding the large mid-December selloff, as the November rally proved unsustainable due to poor market participation.
Figure 2. S&P 500 Performance and Market Breadth
Source: Marketinout.com
The good news is that earnings growth is expected to be strong across the board in 2025, so if some of the unloved sectors can begin to beat earnings estimates we could finally see improved market breadth and more sustainable rallies. Ideally, strong earnings will extend beyond large cap stocks and into small and mid-caps, which have shown glimmers of life but have lagged again as the year ended. Small caps are expected to see earnings per share (EPS) growth of nearly 21% in 2025, exceeding the anticipated 15-16% EPS growth for large caps, and will benefit from any further Fed rate cuts.
The US stock market continues to be the envy of the global financial system, outpacing its developed foreign market peers during the quarter. The iShares MSCI EAFE ETF (ticker EFA) declined -8.4% in the final quarter of 2024, ending the year with a modest 3.5% annual return. Emerging market stocks (using the iShares Emerging Market ETF, ticker EEM) declined less in Q4 at -7.3% and finished the year up 6.5%. Developed foreign markets have struggled under slow growth from traditional economic engines such as Germany and France, which are also dealing with political turmoil. The European stock market is suffering from a lack of innovative companies, as it is dominated by financial firms and underweight technology relative to the US.
The fate of emerging markets is directly proportional to that of its largest constituent, China. Chinese stocks surged in the beginning of the quarter on new economic stimulus measures, but those gains evaporated almost immediately as investors viewed the scope of the policies as insufficient to address the severely distressed property market and astonishing population decline issues. With potentially aggressive tariffs on the table, it is possible that the Chinese government issues increased stimulus measures in the coming year.
Fixed income investors entered the quarter feeling optimistic that rates would begin to fall, and the yield curve would un-invert as the Fed cut its benchmark lending rate. While the yield curve has begun to normalize, it has been due to a sharp uptick in long-term rates. Long-duration Treasury yields have risen back to their 2024 highs, with the 10-Year yield back at 4.6% and 30-Year yields up to 4.8%. Our preference in 2024 was to own a combination of ultrashort government and high yield bonds. High yields were stellar performers in 2024, gaining 8.2% on a total return basis and ultrashort bonds outperformed all other Treasury maturities, gaining 5.3% while the Aggregate Bond Index returned just 1.3% for the year.
Closing Remarks
Just when it looked like the Fed would be on the glide path towards finalizing the soft landing, the transition of Presidential power and some sticky inflation data has put the central bank in a holding pattern for the time being. Luckily, the US economy is on stable footing and corporate earnings are anticipated to accelerate. We think this backdrop supports a continuation of the bull market into 2025, although we saw how quickly the narrative changed in 2024 and know the importance of an agile, tactical approach to asset allocation. We are optimistic about the new year, and the opportunities it will bring.
Thank you, as always, for the opportunity to serve you.